Friday, December 27, 2013


This questionnaire from the NYT is fun. I have what I'm told is a strong southern Ontario accent, and I've picked up some things from living in the U.S. midwest. The questionnaire tells me that I have nothing in common, in terms of dialect, with most of those east of the Mississipi and south of Ohio, most of the eastern seaboard, and Texas. I have most in common with people in Minneapolis/St. Paul and Buffalo NY. Everyone knows that Minnesotans sound a lot like Canadians (and behave the same too), and I grew up 90 miles from Buffalo, as the crow flies. That's pretty accurate. If they had questions about out and about, they would have done even better.

Tuesday, December 24, 2013

Neil Wallace

This post by Dave Altig is excellent. It links to two interviews with Neil Wallace, one in the Minneapolis Fed's Region magazine, and the other a forthcoming Macroeconomic Dynamics interview.

Neil has been a key influence on how I, and people who work in my field of study, think about the world. Today, I still own a well-worn copy of "Models of Monetary Economies," which is a watershed conference volume that changed how many economists thought about monetary economics. Neil is perhaps under-appreciated by the mainstream of the economics profession, but anyone who has been in a seminar room with him knows that few can match Neil in terms of deep and careful thinking about economics.

The two interviews are excellent reading, in many ways. If you look at nothing else, at least read the first section on microfoundations of macro in the Minneapolis Fed interview.

Sunday, December 22, 2013

Minneapolis Redux

Now that the dust has settled on the Minneapolis fiasco, I think it's useful to revisit the issue and learn something from the subsequent discussion. There may be more going on that I don't know about, but to the best of my knowledge, these are the facts in the matter:

1. Pat Kehoe was terminated as an employee of the Federal Reserve Bank of Minneapolis. "Terminated" is when you are told to leave the building.
2. Ellen McGrattan will be a full-time employee of the University of Minnesota as of January 1, and will be on leave from the Federal Reserve Bank of Minneapolis.
3. Kei-Mu Yi, formerly the Research Director at the Minneapolis Fed, is now a Special Advisor to the President of the Minneapois Fed. Kei-Mu's replacement is Sam Schulhofer-Wohl.
4. Second-hand reports tell us that many of full-time employees and consultants at the Minneapolis Fed are uncertain about what (1)-(3) might mean for the institution and for them as individuals. They seem no more informed about why (1)-(3) happened than anyone on the outside.

I was for the most part pleased with how this story was reported in the mainstream media. Reporters at the Minneapolis Star-Tribune, the Financial Times, the Wall Street Journal, and other outlets were fair, I think. They talked to the people involved, and covered the story the way good reporters should. What went on in the economics blogosphere I think is revealing of what this medium can and cannot do. In many cases, bloggers dived into the story and did what they do best. They made stuff up, or repeated things that have become "blog truths" - basically fiction that, when repeated often enough, somehow becomes truthy.

So, this runs from the outrageous to the comical, covering all points in between. First up is Nick Rowe. Nicks points out that Kocherlakota said two "stupid" things in speeches, argues that this was probably the fault of stupid advisers, and so no wonder the stupid advisers were fired.
I think he fired his advisers because he realised they had failed to do their job.
So, first, that's factually incorrect, as only one person was actually fired, i.e. terminated. Second, where Nick sees stupidity, others may not. Nick's first example of stupidity is from one of Narayana's 2010 speeches, which goes like this:
It is conventional for central banks to attribute deflationary outcomes to temporary shortfalls in aggregate demand. Given that interpretation, central banks then respond to deflation by easing monetary policy in order to generate extra demand. Unfortunately, this conventional response leads to problems if followed for too long. The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.
Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.
To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.
In light of what is going on in the U.S. economy, I think that is the most astute thing that Kocherlakota has ever said in public as President of the Minneapolis Fed. I've elaborated on those themes recently, for example this post, and so has John Cochrane. So to my mind, there's nothing stupid about that statement at all - it's conventional economics, it's nuanced, and it's relevant to the policy debate. Same goes for the other "stupid" speech" Nick links to. You could argue the details, but it's perfectly reasonable economics.

What Nick did in his blog post is actually shameful. It's as if he heard that Pat Kehoe was run over by a bus, and concludes that Pat was crossing the street without looking. Nick actually has no idea whether the busdriver was drunk, what was happening on the bus at the time, the condition of the road, how the accident happened, etc. But, he's willing to state in public that Pat Kehoe must have been giving stupid advice. How does he think he can get away with this? That's easy. People will read it, and there are other bloggers out there who will approvingly link to it.

So, that was an outrageous case. Now for the comic relief, which is Kimball and Smith. Some people paint with a broad brush. This is more like when you buy a couple of cans of latex, throw them at the canvas, and go home. From Miles and Noah, I now know that macroeconomics has a soul. And Miles and Noah know how to save the soul from eternal damnation. All we have to do is get rid of those pesky, mathy, "freshwaters" who hate the government, etc., etc. Indeed we are in the process of getting rid of them, as there are "tectonic" shifts in policy circles and in the profession. So don't worry, the macreconomic soul will live in heaven forever after.

If you want to know where Matt Yglesias gets his information, I don't think you have to look much further than Kimball and Smith, and Krugman's blog. Miles and Noah start with the same factual error as Nick Rowe (see how errors propagate in the blogosphere?), i.e. Ellen McGrattan was fired. In putting together their case they want to argue that Pat Kehoe is the member of a tribe:
Patrick Kehoe, one of the economists dismissed from the Fed, is a key figure in a school of economics called “Freshwater Macroeconomics”
So, what is this Freshwater Macroeconomics? Here's how Miles and Noah define it. A freshwater economist
[believes] that people are very, very smart and sensible in their economic decisions...If the Fed prints money to try to stimulate demand, they say, it will only succeed in creating inflation rather than reviving the economy. And given this view of rationality, Freshwater macroeconomics often pushes the idea that the government should keep its hands off the economy in other policy domains as well.
First, the key leaders of the "freshwater revolution" of the 1970s, for example Lucas and Prescott, would never use a word like "believe" to describe what they do. They like to use words like "economic science." If I were to put words in their mouths, I would say that they think that rational expectations is a useful modeling strategy for an economic scientist thinking about dynamic processes. Second, the use of rational expectations models does not differentiate work on sticky prices and wages (what I think Miles and Noah mean by "saltwater") from other work in macroeconomics. If hyper-rationality is a sin, then Mike Woodford is going straight to hell.

The assertion that Miles and Noah make is that Pat Kehoe is a "freshwater" - apparently he thinks that money is neutral, and that government intervention is a waste of time. Let's sift through Pat's work to see if there is any semblance of truth in that. Here is Pat's CV, which, as every academic knows, is the summary of his life's work. First, that' a distinguished record that any academic - anywhere in the world - would be proud of. Pat is a chaired professor at the University of Minnesota, and in the past he has been a chaired professor at Princeton, and has held appointments at the Universities of Pennsylvania and Chicago. Those are some of the elite economics research institutions in the world. In the REPEC rankings, Pat is #105, which is serious business. That's basically top 1% in the world. So, clearly Pat Kehoe was not fired because his research isn't up to snuff as, by any objective measures, the Minneapolis Fed should have been thankful to have him.

What does Pat work on? Here's a paper on financial crises and herd behavior. That certainly doesn't represent a view of the world which says that everything turns out for the best - and it was published in 2004. Here's another paper on monetary policy. That's done in a sticky price framework, where money is certainly not neutral, and policy matters. A third paper is one that I have seen other people mention as evidence that Pat somehow has a biased view of New Keynesian economics. As far as I can tell, this is good science. Pat (and his coauthor Ellen McGrattan) seem to have no special quarrels with New Keynesian theory. Their problem is with the idea that state-of-the-art New Keynesian models can be used directly for policy evaluation. The key problem seems to be that - when viewed through the lens of a New Keynesian model - the data may not necessarily tell us the difference between a "good shock" and a "bad shock," and may therefore fail to give us any information about the correct policy action to take. I would think any serious New Keynesian would want to know about this. The paper is constructive - it tells us what some of the failings of the theory at hand are, and suggests where the research program should go.

So, according to the definition that Miles and Noah give us, Pat is saltwater, not freshwater.

So what direction is the Minneapolis Fed going in? Maybe we can tell by looking at the remaining people there. Well, the new research director is a Chicago PhD with an undergrad Physics degree from Swarthmore, and his most recent work is on development, communications, and demography. Hardly a New Keynesian. What about Kocherlakota's inner policy circle? Of those, Malin has some background in empirical work on price-setting (work with Bils and Klenow for example), but otherwise, no New Keynesians in sight. Further, if you look through the lists of economists and consultants, you won't find a big New Keynesian contingent.

Conclusion: With Pat Kehoe and Ellen McGrattan not at the Minneapolis Fed, the institution is now much less "salty" than previously. In Pat's case, the Fed has lost one of the top experts in New Keynesian economics in the world.

Miles and Noah go on to argue that what they see going on at the Minneapolis Fed is somehow symptomatic of "tectonic shifts" going on elsewhere. As part of the evidence, they argue that Jeff Lacker also "changed his mind," the supporting evidence being this article. As far as I can tell, there has been no dramatic change in how Jeff Lacker thinks about the world - in the article he's only acting surprised that inflation is so low.

So, the case that Miles and Noah want to make sort of falls apart, don't you think? They're basically mischaracterizing what is going on in the profession, and misrepresenting economic science and developments in policy circles. Noah's young, and we can excuse his naivete, but Miles should know better.

Finally, Paul Krugman weighed in on this as well. Krugman is very skillful at character assassination. He does it in such a subtle way - starts off slowly and then builds up to a crescendo using various circumstantial (and carefully selected) "evidence" along the way. Here's the slow start:
What we can ask is what might have led Narayana Kocherlakota, the bank’s president, to conclude that he wasn’t getting value out of research economists with lots of publications in top journals. Kimball and Smith stress the broad failures of freshwater macro predictions — where’s the inflation from all that money-printing? How could something like the Great Recession even happen in a world of clearing markets and optimizing agents?
So, first, Krugman has no idea why Pat was fired. "Wasn't getting value" is just a guess. Then, the suggestion is that, somehow, Pat Kehoe is linked to some "freshwater predictions" about runaway inflation, or views about economically efficient fluctuations. Krugman is just making that up. He apparently has no idea what Pat works on, takes Kimball and Smith at their word (and we already know that those guys are barking up the wrong tree), and goes one step further.

One might also want to look at some specifics. There was Kocherlakota’s speech in 2010 in which he argued that low interest rates cause deflation — presumably with some input from the research economists; this was a big embarrassment, he probably noticed, and it may have fed his doubts about whether his economists had anything useful to offer.
This is the Nick Rowe argument, which I've already dismissed. This would have been "embarrassing" for Narayana only if he took DeLong, Rowe, and Krugman seriously, as they were the guys who ridiculed his speech.

Chari, Christiano, and Kehoe basically sneering at the notion that the financial crisis would sharply raise borrowing costs or have major negative effects on the real economy.
So here he throws in a pejorative - "sneering" - to suggest that these are nasty guys. He's also suggesting that Chari, Christiano, and Kehoe are seriously deluded. He's saying: "Here's a piece of work that is bad, which must mean that the rest of what these people do is tripe as well."

The problem here is that Krugman's lack of knowledge about what's going on in the economics profession is leading him astray. He wants to bring Pat Kehoe and his coauthors into disrepute. But he doesn't understand that some of those guys are actually on his side. He imagines himself in a war, and he's shooting at the wrong guys. Pat Kehoe, Krugman's former Princeton colleague, is actually an important contributor to New Keynesian economics, and Christiano is a big-time New Keynesian these days.

Here's Krugman's finish:
Now, as I’ve tried to say on a number of occasions, mistakes happen. If you, as an economist, try to weigh in on events as they happen, you will get things wrong, and sometimes you may get them wrong in a big way. The crucial question is what you do next. Do you engage in self-analysis, trying to figure out what in your framework led you astray? Or do you double down on your preconceptions, refusing to admit that you may have gone up the wrong path (and, if you’re in an institutional position, try to shut out people with differing views)?

One thing is for sure: people who take the second route don’t add value to a policy-making institution.
Here, you see Krugman's rhetorical gifts on display. Note that he never actually levels the accusation directly against the people involved. But it's abundantly clear what he's saying: "These people were fired because they didn't add value to a policy-making institution. And they didn't add value because they are bad scientists. They said stuff that was wrong, and they persist in their bad science while flagrantly denying the evidence."

So, he said all that without knowing why Pat Kehoe was fired, apparently without gaining any familiarity with what Pat Kehoe actually works on, and without actually providing any hard evidence about where Pat actually went wrong. Is that responsible journalism? Of course not.

So, what does this tell you? Over a long period of time, conventional print journalists were brought to task and forced to take their jobs seriously. Conventional reporters talk to the people involved, quote sources, and provide corroborating evidence. Bloggers do nothing of the kind. Indeed, the guy with the blog which is read by more people in the English-speaking world than any other is a particularly bad example. Much of the time, he's just making it up.

Addendum: I meant to include the following. The blogger who came through this episode behaving like the honest gentleman he is was Mark Thoma.

Saturday, December 21, 2013

Journalists Looking for a Fight

Whenever people start talking about "freshwater" and "saltwater," I wonder what it's all about. I knew what those terms meant in 1975, but since then economic science has evolved and differentiated itself in so many ways that it's hard for me to identify two strands of thought in macroeconomics. But maybe those people know what's going on, in ways that simple me cannot fathom. Now, after reading Matt Yglesias and Paul Krugman, I think enlightenment is here.

First Matt does us the favor of defining "freshwater macro."
freshwater" macroeconomics ... focuses heavily on the idea of a "real" business cycle and disparages the notion of either fiscal or monetary stimulus...
Matt also mentions yours truly:
Stephen Williamson, a proponent of freshwater views...
So, I don't know who Matt has been talking to, but in all of my published work, I don't think you can find a real business cycle model. Further, the models I work with are replete with various frictions - including private information and limited commitment - that make monetary and fiscal policy matter in important ways. I have even on occasion put sticky prices in models, studied credit rationing, and thought about multiple equilibria. So, I guess I couldn't be one of the those freshwaters. Indeed, there appear to be few currently active economic researchers who could actually be pigeonholed as real business cycle types who are sour on government intervention, or somehow don't want to think about it. So what am I, and what is it that most macroeconomists are actually up to?

I think Paul Krugman has the answer, and he makes it simple for us simple-minded folks. You just have to answer a question:
Can you live with that reality, and accept the notion that not everything you put in your model has microfoundations? If you can, you’re a saltwater economist, in some sense a Keynesian. If you can’t, you’re part of what has gone wrong with the field.
Excellent. We're all saltwaters, including Bob Lucas. So, as far as I can tell, Krugman has no one to pick a fight with. Maybe he can go provoke some Austrians. I hear they are very feisty.

Friday, December 20, 2013

Sticky Prices and Liquidity Effects

Apropos John Cochrane's writings on what most people don't know about New Keynesian models, consider this working paper by Alvarez and Lippi. It's not a typical New Keynesian model, as there's money in the model, and menu costs (of a particular form) rather than Calvo pricing. There's money in the utility function, and the money supply is changed through lump sum transfers by the government.

Alvarez and Lippi look at a traditional (in the monetary economics literature) type of monetary experiment. There is a permanent, level increase in the money stock. The model exhibits the kinds of money nonneutralities we would expect to see in a sticky price model. There is a temporary increase in output, prices initially increase less than in proportion to the money supply increase, and money is neutral in the long run. But there's no liquidity effect in the traditional sense. In the experiment that Alvarez and Lippi study, there is no response of the nominal interest rate to the money injection.

However, note that the experiment they are looking at is about fiscal policy, not monetary policy. Money is handed out by way of lump sum transfers - it's not an asset swap by the central bank. I think the key point is that - contrary to what is typically asserted - it is not innocuous to leave the asset quantities out of a New Keynesian model. This avoids addressing important questions, particularly those pertaining to the relationship between monetary and fiscal policy, that are at the heart of the matter.

Thursday, December 19, 2013

Cochrane on Irving Fisher

Well, I'm pleased that at least John Cochrane understands what I'm trying to say. He has other interesting things in his post as well, which are recommended reading.

Wednesday, December 18, 2013


I was asked to write a bit about microfoundations, in response to a couple of posts by Tony Yates and Simon Wren-Lewis, so just a quick note before I grade exams.

I've never much liked the word "microfoundations," which comes from the title of the Phelps volume. When the Phelps volume came out in 1970, micro and macro looked like they came from people living on different planets, and you had to convince people that it made sense to take ideas from Mars and use them on Venus. We know better now, of course, and economics is one unified whole. People who call themselves macroeconomists make liberal use of game theory, mechanism design, information theory, optimal growth theory, etc., etc. Solid economists worked all that stuff out for us to use, and it would be wasteful to leave it on the shelf.

So, it's not microfoundations, it's just economics - it's the foundation, the plumbing, the electrical work, the walls, the roof, etc. What people mean when they say: "you need some microfoundations," is really "you need more detail in there, so we can understand better what the mechanism is that is at work." We would like our models to be deep - everything explained nicely - but any modeler knows that a model must be simple to be useful. So, if there is too much detail we're in trouble. The modeler may have trouble understanding the damn thing, and he or she may not be able to explain how it works to anyone else.

So, where do you draw the line? How deep a structure do we need to say something useful? I just had a discussion with Noah Smith about Calvo pricing. For me, this is as case where we would like more detail. Typically, in a New Keynesian model, pricing is the friction that makes monetary policy matter. So, for that particular model, it's the process by which prices are set that we're worried about. That's where we want the detailed explanation of what's going on. But Calvo pricing is pretty crude. There are two technologies for changing prices. Either a firm can change a price at zero cost, or it's infinitely costly. And which technology the firm has is determined at random. Well, that leaves a lot of unanswered questions. Why would it be costly for a firm to change its price? Why can't the firm write contingent pricing rules? If it's costly to change prices, surely it must be costly for a firm to change other things, like employment. Why does the firm just serve all the demand the comes in the door when its price is fixed? Basically, there's a lot of unfinished business. We're concerned about how things might change if we put in more detail. Do all the results about monetary policy change or what?

Every piece of research has unfinished business. I have a working paper where quantitative easing (QE) matters, and it matters because short-maturity government debt is better collateral than long-maturity debt. What's it mean for an asset to be better collateral? There is limited commitment, and a borrower can run away with a fraction of an asset that is posted as collateral. What determines that fraction? It's just exogenous. That's a piece of unfinished business. I can think of reasons why that fraction could be endogenous in a deeper model, but I haven't worked that out yet.

This brings us to the Lucas critique. Lucas's ideas were related to earlier ideas that came out of the Cowles Foundation, including the original work on identification and structure. When I took Art Goldberger's econometrics class, he asked us one day to find a definition of structure and bring that into class the next time we met. We found 20 or 30 different definitions, some wildly different. Apparently structure is in the eye of the beholder. To give you an idea how thorny this is, I once had an argument with Bob Lucas about the money demand function, which he is very fond of. He was trying to tell me how remarkable it was that he had found a money demand specification that was stable for 100 years. My reply was something like: "Big deal, a money demand function is not structurally invariant to whatever policies we might want to think about using it for." He said something like: "Unfortunately I think the Lucas critique is used as a bludgeon to do away with ideas one doesn't like." I think he said that later in a public venue. So, even Lucas isn't sure what he thinks of the Lucas critique.

Ultimately, we know our models are going to be wrong. That is, to be useful, a model has to be simple, and simplicity implies it's wrong. Theory is obviously important. The data does not speak directly to us and, in contrast to what Simon seems to think, neither does the data speak to us when we filter it through a VAR - that's just another way to summarize the data. Theory gives us principles on which to organize how we think about the data, so that we're not totally lost.

It's hard to define what a good policy model is. Maybe we need different models for different situations - with the detail in different places. In any event, we hope a good economist knows a good policy model when he or she sees it. However, in some cases it may be difficult to evaluate a policy model's worth unless we actually experiment by putting it into practice.

FOMC Statement

Well the FOMC press release surprised me. The big news is that tapering (reduction in the rate of asset purchsases under the current QE program) will begin, with the rate of asset purchases decreasing from $85 billion per month to $75 billion per month - that's a reduction of $5 billion in purchases of long Treasuries, and $5 billion in MBS (mortgage-backed securities) purchases.

There's some different wording in the statement as well. For example:
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.
So, the FOMC is telling us that it is concerned with the low rate of inflation. They're forecasting an increase in the inflation rate over time, to 2%, and if that doesn't happen, projected policy will change in some way. But how? There's some detail on that here (some of this language was in there before, but it may have changed somewhat):
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.
You have to take the part about asset purchases not being on a preset course with a grain of salt. That's what the FOMC told us when they began this current round of asset purchases, but the rate of asset purchases never changed, in spite of new information. Most importantly, note what the FOMC wants to do if inflation comes in below its forecast. That will imply more asset purchases, which will also mean that the liftoff date (policy interest rate above 0.25%) will be pushed further into the future. The Fed insists that QE and the overnight interest rate target are different instruments, and the two elements of policy are not related. That's clearly false. Those two instruments are part of the same policy package, determined by the same group of people.

So, less inflation than expected means "easier" policy. But my key point, in this and other posts, is that this is a trap for the Fed. As long as the policy rate stays close to zero, we should expect inflation to fall. In order to increase the inflation rate over the medium term, the policy rate has to rise. The nature of the trap is confirmed in this sentence:
The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

Other important information is in the Fed's new economic projections. This shows inflation increasing to 2% in the long haul, but still a little below 2% even in 2016. As well, the average forecast is for "firming," i.e. liftoff, in 2015. So, if ideas on the FOMC don't change, my prediction is that 2014 will be disappointing for the Fed on the inflation front - actual inflation will be less than what they're forecasting, and that will push firming/liftoff off into 2016. This will do nothing more than perpetuate the low-inflation trap.

What's the Economics Blogosphere Good For?

I'll give the blogosphere credit for some things.
1. Writing in this medium is addictive. I can swear off it for a while, but sometimes I feel I need a 12-step program.
2. For writers - of textbooks, academic journal articles - this is an excellent workshop for figuring out how to express complicated ideas in ways that people can (hopefully) understand.
3. I have worked in a subfield of economics which has been something of a cult. In days of yore, my work was known mainly to a close family of monetary economists. Now, when I travel and meet professional economists, some of them know who I am because I write this blog. Whether that's good or bad, I have no idea.

Paul Krugman appears to think that the blogosphere has achieved great things. According to Krugman, blog writing is advancing economic science in important ways. Not only that - he thinks the blogosphere is a key outlet for important ideas that have somehow been blocked by Bad-Guy powerful academics who have a tight hold on economics journals. Basically, academic work is bad science, and blog writing is good science.

So, Krugman has been very successful as a blog writer, and he's happy to point out to us that he shows up as #1 on top-100 blog lists. He's like the Eminem/Rihanna of economics. But, if you took a poll of successful academic economists - say the top 2000 on the REPEC list (that's the top 5%) - you know what they would tell you. Some version of: Peer review works, formal economic science is making progress, and most of what is written in economics blogs is schlock. So, who's right?

Please tell me:

1. What evidence do we have of progress in economic science that comes out of blogosphere writing and discussion?
2. What evidence is there that ideas coming directly out of the blogosphere actually influenced policymakers?
3. What are the great ideas that were somehow unjustly shut out of academic journals?

Tuesday, December 17, 2013

FOMC Meeting

The FOMC meets today and tomorrow, and the statement that is issued tomorrow will likely resemble closely the one from October. "Tapering," i.e. a plan for reduction in the rate of asset purchases under the current quantitative easing (QE) program, will be postponed, and the forward guidance language in the statement will remain as is.

A useful document in helping us understand what the FOMC is up to is the text of Bernanke's statement at the June press conference following the June FOMC meeting. This was the unusual case where Bernanke elaborated on the FOMC statement in a public forum, with the approval of the committee. If you read Bernanke's statement at the press conference, most of that is consistent with what the FOMC is thinking today, with at least one important exception, which relates to QE (quantitative easing). In particular, Bernanke said:
And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.
So, things did not evolve in the labor market quite as Bernanke expected. He was anticipating the beginning of tapering in the fall of this year, with asset purchases reduced to zero by about mid-2014, and the unemployment rate at about 7% by that date. Of course, here we are in December, tapering has not started, and the unemployment rate is already at 7%.

Given these past "commitments," one might think the FOMC would be eager to get the tapering show on the road, but apparently not. How come? There are two reasons. First, FOMC members appear to have decided that expressing forward guidance in terms of threshold values for the unemployment rate was a bad idea. You can see this in public statements by various Fed officials. For example, in this speech by Narayana Kocherlakota, he puts some effort into trying to convince us that the decline in the unemployment is not such great news, and that we should be focused on other measures of labor market activity, for example the employment/population ratio. In particular, he shows us this picture:
Charles Evans is on to something related in this speech, but he's focused on this picture:
We aren't given the words that go with the slides that Evans used in his speech, but I'm assuming that the gist was much like what Kocherlakota had to say. Generally, the idea is that it would be a good idea to increase the employment/population ratio, and to close the "output gap," and that monetary policy can and should do something - anything it can in fact - to accomplish that.

Second, the inflation rate has been falling since fall 2011, and is now well below the Fed's 2% inflation target:

So, what could be more obvious to a central banker? Inflation is below its target, the output gap is large, so we need more monetary stimulus, right? We can't get any more stimulus through conventional means, as the policy rate is currently essentially zero, so we should continue to use unconventional means - QE - which we are convinced works. Thus, no hurry to taper, right? And the Fed should continue emphasizing forward guidance, right? Wrong.

Kocherlakota in his speech, makes what I think is a bizarre argument, concluding with this statement:
These low levels of inflation show that the FOMC has a lot of room to provide much needed stimulus to the labor market.
The argument is basically that the central bank always faces a Phillips curve tradeoff, and particularly in this case at the zero lower bound when only unconventional policy is available. Inflation is low, so we can get plenty of stimulus while remaining below the 2% inflation target, according to Kocherlakota.

But the falling inflation rate is actually a signal that the short run effects of past QE are gone, and that the effects of asset purchases get smaller the more you do it. Indeed, with the policy rate at the zero lower bound for more than five years now, no one should be surprised that inflation is low. But there are other voices on the FOMC arguing that continuation of QE at the current rate will make inflation higher than it would otherwise be, and make the "output gap" smaller. For example, in today's New York Times, I read:
“I don’t buy this diminishing returns thing,” James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview with Bloomberg Television last month. “If you lowered the funds rate from 5 percent to 4 percent, and then you lowered it from 4 percent to 3 percent, you probably wouldn’t say that the second hundred basis points was less effective than the first 100 basis points. And I don’t think we should say that about the Q.E. program either.”

What about forward guidance? The nature of that guidance has changed a lot over time. The FOMC started with "extended period" language in the FOMC statement. The fed funds target range was to stay at 0-0.25% for an extended period of time. Then, we were given more specific information. The fed funds rate was to stay low at least until some date in the future. Then that date was pushed further into the future. Then, a "threshold" was announced - the fed funds rate was to stay low at least until the unemployment rate fell below 6.5%. But now, it seems clear that 6.5% means nothing at all. The last FOMC statement from October says:
the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.
So now we have a whole lot of forward guidance. But what's it actually say? About as much as the FOMC would have said, or implied, before the financial crisis happened. They will look at everything, and then come to a decision. So, what was all that extended period/calendar date/threshold stuff about? What indeed?

The Fed has not been in a situation like this. They are making it up as they go along, and acting as if they know what they're doing. Now they're in a situation in which they're trapped by old thinking, and I don't think it's going to go well. So,

1. The FOMC needs to recognize that there is nothing more they can do that can affect real economic activity in the way they want while at the zero lower bound. The short run effects of unconventional monetary policy, to the extent that those effects are in fact quantitatively significant (which we really don't know), have played themselves out.
2. We're in a state where most of the forces at play look like they will tend to reduce the inflation rate over time if the policy rate stays effectively at the zero lower bound. Postponement of the "liftoff date," which looks like it could be in 2015 or later, only lengthens the period of time with inflation below the 2% target.
3. To get inflation up, the policy rate has to increase.

Monday, December 16, 2013

Grilled Cheese Sandwich

This relates to this post, and this one. To quote myself:
If I want to find a Phillips curve relationship in the data, then through some process of specification searches, Bayesian estimation with alternative priors, or whatever, I will be able to find it. If I'm looking hard for the Virgin Mary, I can find her in a grilled cheese sandwich.
So, Paul Krugman has gone searching for the Virgin Mary and, big surprise, claims success. Of course I can take Krugman's two time series and find something else. Here is the data from October 2009 (peak unemployment) to November 2013:
In that figure, the line joins observations for October 2009 on the far right with November 2013 on the far left.

Note two things:
1. Unemployment and wage inflation are positively correlated over that four-year period.
2. Sometimes unemployment is falling when wage inflation is falling; sometimes unemployment is falling when wage inflation is rising.

Krugman seems to forget the key lesson of the 1970s Phillips curve debate, which is that you need theory - structure - to make sense of what we see in the world, in a way that is useful for policy.

Finger on the Pulse?

Some journalists are able to get inside what is going on in a technical subject, and explain it well for lay people. But this post by Paul Krugman left me puzzled. He says:
At this point, however, there is wide acceptance of the idea that for a variety of reasons, but especially downward nominal wage rigidity, the Phillips curve is not vertical at low inflation.
What Krugman seems to mean is that, in the long run, there is a tradeoff between unemployment and inflation at low rates of inflation. The claim is that this is "widely accepted."

So, first, I have no idea who "accepts" this idea. I haven't heard about it, except in Krugman's blog posts. And why do the accepting people find it so acceptable? Is there a theory? Krugman says its wage rigidity that explains this. Has he written down a theory? Has someone else written down a theory? Has that theory been confronted with the data?

On the empirical front, let me reproduce two charts from my last post. First, let's look at a scatter plot of the pce inflation rate vs. the difference between the unemployment rate and the CBO natural rate of unemployment (quarterly, 1955-2013):
So at low rates of inflation, say below 2%, do you see this long-run tradeoff? I don't.

Next, look at what's been happening for the last 9 quarters:
So, forget about the long-run tradeoff. Krugman has some explaining to do about the short-run tradeoff.

Sunday, December 15, 2013

Phillips Curves and Fisher Relations

I think most of us know about Phillips curves. The typical story that goes with the Phillips curve is something like: "When there is a lot of slack in the economy and unemployment is high relative to the 'natural rate,' demand is low, and firms don't want to raise their prices, so inflation is low. When the unemployment rate is low relative to the 'natural rate,' inflation should be high." Of course it's well known that you have to work hard to see that in the data. For example if we plot pce inflation vs. the difference between the unemployment rate and the CBO natural rate of unemployment (quarterly, 1955-2013), we get:
Can't see the Phillips curve there, right? We think there are good reasons for that. There are various shocks hitting the economy from quarter to quarter - some large, some small. Some of those shocks make unemployment and inflation move in oppposite directions, some make unemployment and inflation move in the same direction. That will produce some of the scatter in the chart. Further, in the long run, inflation should have little or no effect on unemployment (Milton Friedman argued for no effect). The modern search theory of unemployment seems to tell us that higher long-run inflation is associated with higher long-run unemployment. Indeed, if we do a reverse regression with the variable on the horizontal axis in the chart serving as the dependent variable, we can fit a long-run Phillips curve to the data, and that's the regression line in the chart. You can see there's not much of a slope to it.

As I mentioned above, if we work hard enough we can find a Phillips curve relationship. For example, if we think there is an episode where monetary factors were important, then we should see the Phillips curve over that period, as monetary shocks tend to move inflation and the unemployment rate in opposite directions in the short run. So, consider the period of time between fourth quarter 1980 and third quarter 1982, when Paul Volcker was using monetary policy to bring the rate of inflation down. For that period, we get:
Of course, economic theorists warned us about the Phillips curve. Even if we think we see a strong relationship in the data, we need theory to understand what it means. It is possible to make serious policy errors if we treat an observed statistical relationship as part of the structure of the economic model which is going to be used to guide economic policy.

One of the more puzzling aspects of New Keynesian economics is the enthusiasm for bringing the Phillips curve back into the mainstream. After the 1970s, the Phillips curve had a low profile in academic work, but has had a resurgence since the 1990s in the form of the "New Keynesian Phillips curve." If you know how the discourse has evolved in central banks over time, you'll also know that, whatever was going on in the economics journals, central bankers never lost their affection for the Phillips curve. That's part of what makes New Keynesian economics attractive for them.

In part, the Phillips curve is used in central banks for forecasting. Indeed, that tendency is not confined to central banks, as the note attached to the CBO natural rate series in FRED indicates:
The short-term natural rate is used to gauge the amount of current and projected slack in labor markets, which is a key input into CBO's projections of inflation.
My best guess is that the Federal Reserve Board's inflation forecasts, which seem to rely on the FRB/US model, or other mechanisms kept secret from those of us on the outside, put significant weight on output gap measures. You can see that in published Fed inflation forecasts, which typically show inflation well below the 2% inflation target in the immediate future, and reverting to 2% over a period of three years or more, because they view the output gap as high and falling.

So, policymakers seem to think that the output gap, say as measured by the deviation of the unemployment rate from the natural rate, is useful in forecasting inflation. But to comment on usefulness, we have to run a horse race. So, let's set the bar really low. Suppose I am a very lazy forecaster, and my forecast for next quarter's inflation rate is this quarter's inflation rate. If the output gap is useful in predicting inflation, then if we deliver output gap measures to our lazy forecaster, he or she should be able to make a better forecast. One indication of what the lazy forecaster has to gain is that, if he or she ignores the output gap measure, he or she should make forecast errors that are correlated with the output gap. If the output gap is high, he or she will tend to miss on the low side, and vice versa if the output gap is low. So, let's check that out.
As you can see, the lazy forecaster's errors are uncorrelated (the correlation coefficient is -.05) with the difference between the unemployment rate and the natural rate. In this sense, a monkey can forecast inflation as well as an economist armed only with a Phillips curve. This is in the spirit of what Atkeson and Ohanian told us long ago.

Perhaps more embarrassing for Phillips curve enthusiasts is what is going on in the recent U.S. data. The last 9 quarters of data (2011Q3 to 2013Q3) looks like this:
So, if I lie on my left side and look at that, it's a nice Phillips curve.

Whether central bankers are embarrassed is not clear. They certainly are puzzled, though, as this WSJ article indicates:
Mr. Bullard has also underscored that even as the economy’s outlook has improved, inflation continued to undershoot the Fed’s 2% target, and central bankers don’t have a good explanation for why this is happening.

Conclusion: If I want to find a Phillips curve relationship in the data, then through some process of specification searches, Bayesian estimation with alternative priors, or whatever, I will be able to find it. If I'm looking hard for the Virgin Mary, I can find her in a grilled cheese sandwich. But Phillips curve thinking isn't helping monetary policy right now. It just makes people puzzled.

So, my attempt in what follows is to reduce puzzlement. While the Phillips curve can be hard to find in the data, the Fisher relation is not. From the same data set that produced the first chart, we get:
So, over the long run, there's a clear positive correlation between the nominal fed funds rate and the pce inflation rate. Irving Fisher taught us that, in credit markets, borrowers and lenders care about real rates of return. Thus, there should be an inflation premium built into the observed nominal interest rate - if the inflation rate is higher, the nominal interest rate should be higher. This just compensates lenders for the decline in purchasing power they experience between the time a loan is extended and when it is paid back. Indeed, some mainstream models, including New Keynesian models (which are basically neoclassical growth models with sticky prices and wages) have the feature that the long-run real interest rate is a constant, determined by the subjective rate of time preference of the people who live in the model.

So, if we suppose that the real rate of interest is constant in the long run, we might fit a straight line to the points in the chart above (as I have done), and then think of the deviations from that straight line as short-run deviations from a "natural real rate of interest." One factor that may cause the real interest rate to fluctuate in the short run is monetary policy. In particular, some models of the short-run nonneutrality of money tell us, and central bankers certainly have told us for a long time, that in the short run monetary tightening - an increase in the nominal interest rate - makes the real rate of interest go up and the inflation rate go down. That's a feature of New Keynesian models, and it also comes out of other traditions. For example, segmented markets models exhibit a liquidity effect (real interest rate goes down in response to monetary stimulus in the short run), one example of which is this Alvarez/Atkeson/Kehoe model.

You can see the liquidity effect in the data from the Volcker disinflation period.
In the picture the trend runs from northeast to southwest - that's the Fisher effect at work (lower nominal interest rate and lower inflation). But there are periods of time when inflation is falling and the nominal interest rate is rising - that's the liquidity effect. An important observation from this period is that the liquidity effect is relatively short lived. That is, the Fisher relation may be a long-run phenomenon, but this isn't an in-the-long-run-we-are-dead long run.

Here's a heuristic approach to this. This, I think, is roughly what you would get if you took some of the models I have been working with, and put in aggregate shocks and short-run liquidity effects. First, suppose that the long-run real rate of interest is a constant. Then, in the next chart, LRFR is the long-run Fisher relation.
So, suppose I am Paul Volcker, and I'm faced with a situation at point A where the inflation rate is high and the nominal interest rate is high. The curve SRLE1 is the short-run tradeoff I face. I can reduce inflation in the short run by increasing the nominal interest rate, thus moving to B. But that won't work to reduce inflation in the long run, so after increasing the nominal interest rate, I have to begin reducing it. In that process, the short run tradeoff shifts down. Ultimately the economy comes to rest at point D where inflation and the nominal interest rate are both lower, and the short run tradeoff is SRLE2.

Next notice, in the Fisher relation data chart, that a nonlinear long-run Fisher relation would fit better than a straight line. That is, at low rates inflation, the real interest rate tends to be low. I get an effect like that in some of my work, and it comes essentially from an effect on the liquidity premium associated with interest-bearing safe assets. So, in the next chart, the curve LRFR1 denotes the long-run Fisher relation, which is concave.
So, one long run equilibrium is at point A, at the zero lower bound. Of course, the nominal interest rate can't go below zero. But, our central bankers argue, QE (quantitative easing) works just like a reduction in the fed funds rate. In some of my work, that's close to being true, so suppose we accept that. Then, effectively we have a short-run tradeoff SRLE, and it's as if we can get more inflation by moving down that curve to point B. But, the lesson from the Volcker era is that short-run liquidity effects are short-lived. Further, my work shows that there is another liquidity effect, associated with the interest bearing liquid assets, that causes the long run real rate to increase as a result of QE. So the long-run Fisher relation shifts up to LRFR2, and the long-run equilibrium is at E, as a result of QE, which implies lower inflation. And remember we don't have to wait long for this long run.

Further, there are other forces in play currently that will tend to move point E to the left if the nominal interest rate stays at zero. The destruction of private sources of collateral and the shaky state of sovereign governments in parts of the world gave U.S. government debt a large liquidity premium - i.e. those things reduced real interest rates. As those effects go away over time, real rates of return will rise, shifting up the long-run Fisher relation, and reducing inflation if the Fed keeps the nominal interest rate at the zero lower bound.

If the Fed actually wants to increase the inflation rate over the medium term, the short-term nominal interest rate has to go up. We need to be at a point like D. There used to be a worry (maybe still is) of "turning into Japan." I think what people meant when they said that, is that low inflation, or deflation, was a causal factor in Japan's poor average economic performance over the last 20 years. In fact, I think that "turning into Japan" means getting into a state where the central bank sees poor real economic performance as something it can cure with low nominal interest rates. Low nominal interest rates ultimately produce low inflation, and as long as economic stagnation persists (for reasons that have nothing to do with monetary policy), the central bank persists in keeping nominal interest rates low, and inflation continues to be low. Thus, we associate stagnation with low inflation, or deflation.

So, here's the policy advice for our friends on the FOMC. Continuing to engage in short-run monetary stimulus, through QE, will have little or no effect on real economic activity. The short run stimulative effects of monetary policy have pretty much played themselves out, and the real effects get smaller the more you do it. If there's any tendency for inflation to change over time, it's in a negative direction, as long as the Fed keeps the interest rate on reserves at 0.25%. Forget about forward guidance. You've pretty much blown that, by moving from "extended period" language, to calendar dates, to thresholds, and then effectively back to extended periods. That's cheap talk, and everyone sees it that way. So, as long as the interest rate on reserves stays at 0.25%, there are essentially no benefits in terms of more real economic activity. But you're losing by falling short of the 2% inflation target, which apparently you think is important. And you'll keep losing. So, what you should do is Volcker in reverse, except you don't have to move the inflation rate up much. For good measure, do one short, large QE intervention. Then, either simultaneously or shortly after, increase the policy rate. Under current conditions, the overnight nominal rate does not have to go up much to get 2% inflation over the medium term. Otherwise, you're just stuck in a rut, which would be too bad.

Monday, December 9, 2013

UI and Unemployment

I was reading Paul Krugman's NYT column this morning, and ran across the following:
Proponents of this story like to cite academic research — some of it from Democratic-leaning economists — that seemingly confirms the idea that unemployment insurance causes unemployment. They’re not equally fond of pointing out that this research is two or more decades old, has not stood the test of time, and is irrelevant in any case given our current economic situation.
I'm not sure what research the "proponents of this story" or Krugman are paying attention to, but the mainstream theory of search and unemployment - our standard tool for understanding how the labor market works - is both old and new, has certainly stood the test of time, and it tells us that more generous unemployment insurance (UI) increases the unemployment rate.

In standard search models, there are several channels through which UI affects the unemployment rate. In early one-sided search models, e.g. McCall (1970) an unemployed worker searches until he or she finds a job that is sufficiently attractive. The unemployed worker has a reservation wage strategy - offers at or above the reservation wage are accepted and those falling below it are rejected. More generous UI makes the opportunity cost of searching lower, and the unemployed worker increases his or her reservation wage. Why not be more picky if searching is less painful? This tends to increase the average duration of unemployment for any unemployed worker, and therefore to increase the unemployment rate.

Economists later developed two-sided search models. The big innovators in this research area were Dale Mortensen and Chris Pissarides. In a two-sided search model there are firms looking for workers, and would-be workers looking for firms, and it takes time for them to match. In this model, the effect of UI works somewhat differently from what happens in the one-sided search model. In a Mortensen-Pissarides (MP) model, most or all of the action is isolated in the behavior of firms. Unemployed workers simply search no matter what, but firms face a choice as to whether or not to bear a cost of searching for workers (posting a vacancy). If UI is more generous, this makes the bargaining position of workers better when negotiating with firms, because the opportunity cost of rejecting a job offer is lower (in this sense the effect has some similarity to what happens with one-sided search). This has the effect of increasing the wage the worker receives, which is bad for firms. As a result, fewer firms post vacancies in the labor market, the job finding rate of unemployed workers drops, and the unemployment rate rises.

Another strand of economic research studies the optimal design of UI systems. Like any form of insurance, UI is doing something useful - it provides insurance - but there are incentive effects to worry about. Insurance companies that provide auto insurance and fire insurance understand that there is a moral hazard problem - the better the insurance the less care the insured takes to prevent a loss. And it is difficult to observe the insured's effort in preventing losses. Similarly, in the case of UI, the search effort of an unemployed worker will affect the would-be worker's chances of finding a job, and that search effort is difficult to observe. More generous UI, as above, reduces the opportunity cost of searching for work, and one of the adjustments the would-be worker makes is to put less effort into search. This increases the average duration of unemployment and the unemployment rate. Work in this area (e.g. Hopenhayn and Nicolini's work) shows that, if the UI system is designed to account for moral hazard, that UI benefits should last for a long time after a worker becomes unemployed, and the benefit level should decline during a worker's spell of unemployment.

These predictions - which come from theory - are broadly consistent with empirical evidence. For example, if we look at a cross section of countries, what we observe is that countries with more generous UI systems than in the US (Western Europe, UK, Canada) tend to have higher unemployment rates.

Search models have been very widely used, and they are currently ubiquitous. They're used by labor economists and macroeconomists (New Keynesians too). Further, Diamond, Mortensen, and Pissarides received the Nobel prize in economics for their work on search theory. Quoting from the Nobel committee's announcment:
This year's three Laureates have formulated a theoretical framework for search markets. Peter Diamond has analyzed the foundations of search markets. Dale Mortensen and Christopher Pissarides have expanded the theory and have applied it to the labor market. The Laureates' models help us understand the ways in which unemployment, job vacancies, and wages are affected by regulation and economic policy. This may refer to benefit levels in unemployment insurance or rules in regard to hiring and firing. One conclusion is that more generous unemployment benefits give rise to higher unemployment and longer search times.
Note the last sentence.

UI benefits were extended for the long-term unemployed in the US during the last recession, and those extended benefits are still in place. Krugman wants to argue that cutting off those benefits would be bad policy. There may be good reasons why Krugman's conclusion is correct. For example, the standard UI system in the US whereby benefits are cut off after 6 months may be suboptimal. As well, it may be the case that the effect of extended benefits on the unemployment rate is not quantitatively important. But it only weakens Krugman's case to make statements that are false.

Further, in the quote I started with, Krugman seems to want to argue that there is something about our current situation that is so different that everything we know gets turned on its head. That's not so obviously false, but I think it's incorrect.

Sunday, December 8, 2013

Volcker and Bernanke

The other day I met an intelligent person from the Moon. Apparently this Moon Person (MP) knows nothing about what goes on here on earth, with the exception of: (i) Paul Volcker was the Fed Chair from August 1979 until August 1987; (ii) The Fed controls the nominal federal funds rate; (iii) Paul Volcker is well known for bringing down the rate of inflation in the United States.

I showed MP the following chart.

Me: So, how did Paul Volcker reduce inflation?
MP: Well, it looks like he did it by reducing the fed funds rate.
Me: But, look at how the fed funds rate goes up in 1980-81.
MP: Sure, but the big picture is that Volcker walked into the job with an inflation rate of 10% and a fed funds rate at 13.75%, and walked out the door with the inflation rate at about 3.5% and the fed funds rate at 7%.
Me: OK, fine. But, here's something else I want you to think about. There is a guy, Ben Bernanke, who was appointed Fed chair in February 2006, and will walk out the door in January, 2014. Now that we've warmed up on the Volcker era, here's a chart (not quite the Bernanke window, but I want to make this 32 quarters, just like Volcker) that shows you how things evolved during Bernanke's 8 years.

Me: So tell me, what's going on here?
MP: Well, there's some weird shit going on in that shaded area, but it looks like this guy tried to do the same thing as Volcker. He dropped the fed funds rate, and inflation fell from the time he came into office until he was about to leave. I notice as well that Bernanke increased the fed funds rate early in his tenure. Also, he doesn't seem to be as good an inflation fighter as Volcker. Bernanke reduced inflation from 3% to 1%, but he had to reduce the fed funds rate from 4% to close to zero to do it. When Volcker reduced the fed funds rate, he reduced the inflation rate about one-for-one, in terms of percentage points, but Bernanke gets a reduction of about 1/2 percentage point in the inflation rate per percentage point reduction in the fed funds rate. Must be something Bernanke was doing wrong. Is he a dimwit?
Me: First, watch your language. Second, Bernanke is no dimwit.
MP: Well, sure looks like it. Convince me.
Me: Long ago there was a man named Irving Fisher, who thought about how inflation and nominal interest rates are related. Roughly, the real interest rate - what people actually care about when they make economic decisions - is the nominal interest rate minus the inflation rate. If it were true that, over a long period of time, the real interest rate were unaffected by monetary policy, then a one percent decline in the nominal interest rate should result in a one percent decline in the inflation rate.
MP: Cool. That seems to be what happened with Volcker in that first picture you showed me. This Irving Fisher guy was no dimwit.
Me: Well he wasn't infallible. Fisher was also famous for giving the academic institution where he worked bad investment advice, and making that place poor.
MP: That's too bad.
Me: No, don't worry. They got rich again. But, we digress. Notice what happened with Bernanke. The difference between the fed funds rate and the inflation rate is what we could the "ex post real fed funds rate."
MP: And that declined during Bernanke's term by about 2%. Interesting. So what would make that happen? Maybe it has something to do with that weird crap and the shaded area.
Me: You catch on quickly. The shaded area is a recession. We've seen plenty of those. A recession is basically bad crap, but this particular recession involved weird crap as well. It's my understanding that the weird crap associated with the bad crap made the real interest rate go down.
MP: So, if the real interest rate went down, Irving Fisher would tell us that inflation wouldn't fall as much when Bernanke reduced the fed funds rate. So Bernanke's no dimwit. He's just a victim of bad crap and weird crap.
Me: Excellent, you're catching on. Another way to look at this is in the next couple of pictures. The first shows a scatter plot, with the dots connected to show you the path that the fed funds rate and inflation followed in the Volcker years, and in the Bernanke years. The second is the same scatter plot without connecting the dots.

MP: Yes, I see. Irving Fisher's relationship shows up clearly in that plot. And if I fit a regression line to the Volcker points and the Bernanke points separately, the relationship shifts down in the Bernanke years. That's the decline in the real interest rate.
Me: They teach regression on the Moon?
MP: Yes. But, now I'm wondering. That shaded area in the second chart ends in early 2009, so I guess the bad crap is over. If the weird crap is over too, and weird crap makes the real interest rate low, why isn't the real interest rate back to normal?
Me: Well, first, it's not clear what normal is. Second, the weird crap is persistent - that's part of what makes it weird. But there are good reasons to think it's going away.
MP: Ah, I see. So if it's going away, and the fed funds rate stays at zero, then the inflation rate should be falling, just like Irving Fisher tells us. That seems to be what is happening in the second chart.
Me: Excellent. You are really quick.
MP: But, now I'm wondering, what's this inflation anyway? Is that some bad crap too?
Me: Yes. That's why Volcker wanted to get rid of it. Everyone agreed that the high inflation in 1979 was bad crap, and Volcker listened.
MP: So, it looks like Bernanke did a good thing. Less bad crap inflation.
Me: No, that's not the thinking. Bernanke and his henchpersons have agreed that 2% inflation is the best we can do. Less is bad crap. More is bad crap.
MP: I thought you were telling me this Bernanke character is not a dimwit. Looks like he just went from bad crap (3% inflation) to more bad crap (1% inflation).
Me: No, it's more complicated than that. For example, notice that Volcker had a bad crap period in 1981-82. We think that the bad crap shaded area in that case was caused by the attempt to reduce inflation.
MP: I see. So Volcker gave us some bad crap for a short time to give us good crap for a long time. Seems like a good idea. And it must work in reverse. If there is bad crap, we can make the bad crap less bad for a short time by lowering the fed funds rate.
Me: Yes, that's exactly the thinking.
MP: But lowering the fed funds rate and keeping it there for a long time means low inflation, and bad crap for a long time.
Me: Yes, that too.
MP: So, I think I know what Bernanke's successor should do. Who is that anyway?
Me: Janet Yellen.
MP: Good. On the Moon we let women run everything. Works much better. The men only play competitive sports, and dissipate their aggressive energy in harmless ways. Anyway, it looks as if Yellen should just increase the fed funds rate. For the time being, it won't have to go up much, so there should be little short-term bad crap to worry about. And you'll get the good crap permanently because the inflation rate will go back to 2%. But it seems like the typical thing to do (Volcker in reverse) if you want to increase inflation is to reduce the fed funds rate for a short time, and then increase it. So Yellen should do that.
Me: There's a problem with that. Financial markets won't let the fed funds rate go below zero. But there's something else that can be done. That's called quantitative easing, or QE.
MP: So what's that do?
Me: No one is quite sure. On Thursday evening, one of Bernanke's henchpersons, Jim Bullard, talked to us. He likened QE to a reduction in the fed funds rate.
MP: OK, so if we take Jim at his word, then some of that QE should be done. After that, the fed funds rate should go up.
Me: You're way ahead of the game. They already did that - the QE part. Actually, they've been doing it off and on for about five years, and now QE is going at full bore.
MP: That seems odd. If I think that reducing the fed funds rate gives some temporary relief from bad crap, or some short term good crap, why would they keep doing that? If, as Jim says, QE is just like a reduction in the fed funds rate, then if I keep doing it, that should just make inflation lower. So we get no more good crap, only a perpetuation of successively worse bad crap.
Me: You're good at this. Maybe someone should find you a job in the Federal Reserve System.
MP: Whatever. Anyway, it looks like the counterpart of reducing the fed funds rate temporarily has already been done. So, either Bernanke, or Yellen in her new term, should be increasing the fed funds rate. Get that show on the road.
Me: Well, there are no plans for doing that in the immediate future.
MP: Are those people d...
Me: Don't say it. Things are complicated.
MP: My head hurts. Let's go to the coffee shop.

Thursday, December 5, 2013

Daily Chuckle

What's the difference between a New Keynesian, an Old Monetarist, and a New Monetarist? A New Keynesian thinks no assets matter, an Old Monetarist thinks that some of the assets matter, and a New Monetarist thinks all of the assets matter.

Wednesday, December 4, 2013

Intuition Part II

Here's some more intuition to add to this post. It's interesting to consider what is going on with respect to consumption and labor supply behavior as well. Take my cash-in-advance notes as a starting point.

Here's what happens in a conventional sticky-price New Keynesian model at the zero lower bound. Anticipated inflation is essentially fixed (anchored), and the central bank would like to lower the real rate of interest but cannot do so. Thus, the real interest rate is too high, which makes consumption too low. Firms hire fewer workers "because demand is low," and for the workers to be happy with working less, the real wage must be low.

In my model, consumers need liquid assets to purchase goods. Here, liquid assets include all assets - not just money - that have some use in exchange or as collateral. In the model, the economy can be in a state where there is a shortage of liquidity. The low supply of liquid assets makes consumption low. Indeed we could say that "demand" is low, though I'm not a big fan of that language (as it's misleading in general equilibrium). The people living in this world work today, acquire assets, and consume tomorrow by selling the assets. When there is a shortage of liquidity, firms hire fewer workers, and the workers are reconciled to working less because the return they are getting on their assets is low - that's another way of looking at the high liquidity premium. The real rate of return on assets is essentially determining the effective wage the worker faces, so what's going on in the labor market looks exactly the same as in the New Keynesian model - the real wage is low. What's different is that the real interest rate is not too high, it's too low.

Then, suppose the central bank comes along and does quantitative easing (QE). This increases the stock of liquid assets (say, because long-maturity government debt is worse collateral than short-maturity government debt). This relaxes constraints for consumers, and consumption goes up - it's "demand stimulus," if you like. Firms want to hire more workers, but the workers have to be reconciled to working harder, so their real wages need to go up. This means that the real return they receive on their assets must be higher. At the zero lower bound, the only way that can happen is if inflation goes down.

So, if I were inclined to do it, I could sell that as Keynesian story. The inefficiency in this economy arises from a shortage of liquidity. Relieving that liquidity shortage through QE has the effect of increasing spending and wages. But inflation goes down and the real interest rate goes up. And less inflation is associated with more output. No Phillips curve for sure.

Tuesday, December 3, 2013

The Intuition is in the Financial Markets

I thought I would take another stab at giving Paul Krugman some intuition about what I have written about here, here, and here.

Krugman quotes something Andolfatto wrote, and then writes:
OK, so “agents require” a fall in the inflation rate to induce them to hold more currency. How does this requirement translate into an incentive for producers of goods and services — remember, we’re talking about stuff going on in the real economy — to raise prices less or cut them? Don’t retreat behind a screen of math — tell me a story.

So, let's take that seriously. We'll tell a story, but telling a story about pricing in goods markets is not going to get at the essence of the problem. For Krugman, and for many macroeconomists, pricing is indeed the essence of the problem - their problem, not mine. Five years ago we went through a financial crisis, and we call it that for good reasons. Most of us are in agreement that the problem was financial. Thus, if we're looking to understand the crisis and its aftermath, we should start by thinking about financial markets. Financial market problems can indeed create problems for how goods markets and labor markets function, and that's part of what we want to understand.

Here's the story. No symbols. No equations. No numbers even.

Let's start with basic things we know about financial markets, neglecting risk for now. Savers who hold assets care about the rates of return on those assets. Indeed, what would seem to have to be true in a world without risk is that the rates of return on all assets would equalize - otherwise who would want to hold the low-return assets? But, we observe that, in the real world, different assets have different rates of return. Risk can explain some of that, but there are some assets - take currency and U.S. Treasury bills, for example - which appear to have exactly the same risk characteristics, but typically have different rates of return.

How to explain rate-of-return differentials? We might suppose that people just like some assets better than others. For example, maybe they enjoy holding General Motors stock more than they enjoy Microsoft stock. This might help us explain the rate of return on housing, relative to other assets, for example. If I own a house and live in it, I get an implicit flow utility return, and this will make me willing to hold a low-return house as an asset rather than high-return General Motors stock. Of course, I'll need to be concerned about the fact that it's possible to invest in housing as an asset and rent it out. In any case, trying to explain some rate-of-return differentials by positing a flow utility return from the asset won't be very satisfying in most contexts. For example, that won't produce any revelations if we're trying to explain why the rate of return on T-bills is typically higher than for currency.

But economists think about another factor - often expressed in vague terms - which helps to explain the rates of return on assets. That other factor is liquidity. So what is it? Liquidity is some extra value we get from an asset - a payoff not captured in it's measured rate of return - that comes from its acceptability in exchange for other assets or consumption goods, from its use as collateral in credit contracts, or for other reasons. We can all understand that currency is more liquid than T-bills, in the sense that no one accepts T-bills in retail transactions, but currency is widely accepted. However, there is a sense in which T-bills could be more liquid than currency in particular uses. For example T-bills are much more convenient for use as collateral in overnight repurchase agreements. Ultimately, it seems liquidity is a matter of degree. It seems hard to separate assets into the liquid and not-liquid. In one sense, a house is illiquid, in that it is hard to sell - not much use in making retail transactions, for example. In another sense, it has some liquidity value because homeowners can take out a home-equity loans using their houses as collateral.

We can conclude, though, that if the rate of return on asset A is higher than the rate of return on asset B, then part or all of the explanation for this is that asset A is less liquid than asset B. In other words, the two assets can carry liquidity premia - implicit flow liquidity returns - and the differences in rates of return in asset A and asset B could be all or partly due to differences in liquidity premia on the two assets, with the liquidity premium on asset B being higher.

So, those are some things we know about the determinants of rate-of-return differentials. What explains the average rate of return or, put another way, the aggregate rate of return on assets in an economy? That's just supply and demand logic. The demand for assets comes from the willingness of savers to hold those assets, and supply is determined by the actions of firms, financial intermediaries, and the government. Given demand, an increase in the supply of available assets will cause the rates of return on all assets to go up, so as to induce savers to hold those assets.

It's generally recognized that the effects of central bank actions in financial markets have something to do with liquidity. A conventional open market purchase is basically a swap of money for short-term government debt. Under conventional conditions, the rate of return on short-term government debt is higher than the rate of return on money (the nominal interest rate is positive), and that has to be solely due to the liquidity premium being higher on money than on short-term government debt, as money and short-term government debt have basically the same payoffs - they're equivalent in terms of risk. So under conventional conditions (a positive nominal interest rate) an open market purchase increases the average liquidity of assets in financial markets. How that matters is of course the subject of an enormous amount of theorizing and empirical work.

To get to the point, let's think about what happens in a liquidity trap. What's that? For some reason, possibly engineered by the central bank, the economy is in a state where the rates of return on money and short-term government debt are the same. The nominal interest rate is zero. Further, the rate of return on both of these assets is equal to minus the inflation rate. What is happening with liquidity premia in this liquidity trap? In the trap we are currently in, one can make the case that the aggregate stock of liquid assets is relatively small. Treasury debt and the liabilities of the Fed are liquid assets, but there are other liquid assets that are created by the private sector. Such private liquid assets include the liabilities of financial intermediaries and asset-backed securities. The financial crisis acted to reduce the supply of these private liquid assets, and we can also argue that there was an increase in the demand for U.S. liquid assets, coming from the demand abroad for our Treasury debt. Thus, in the liquidity trap we are in, the liquidity premia on money and short-term government debt are the same, and positive.

Next, conduct a thought experiment. What happens if there is an increase in the aggregate stock of liquid assets, say because the Treasury issues more debt? This will in general reduce liquidity premia on all assets, including money and short term debt. But we're in a liquidity trap, and the rates of return on money and short-term government debt are both minus the rate of inflation. Since the liquidity payoffs on money and short-term government debt have gone down, in order to induce asset-holders to hold the money and the short-term government debt, the rates of return on money and short-term government debt must go up. That is, the inflation rate must go down. Going in the other direction, a reduction in the aggregate stock of liquid assets makes the inflation rate go up.

But in a liquidity trap, since money and short-term government debt are equally liquid, if the central bank swaps one asset for another then this has no effect. That's why we call it a liquidity trap. Similarly, suppose that short-term government debt is more liquid than long-term debt. To be more precise, short-term debt may be a more preferable asset to use as collateral, perhaps because its market price is less volatile. Then, even though we are in a liquidity trap, quantitative easing (QE) - swaps by the central bank of money or short-term government debt for long-term government debt - will increase the effective stock of liquid assets in the aggregate. Just as I outlined in previous paragraph, that has to reduce the inflation rate.

What's the qualification? There are various short-run effects of monetary policy that could come into play. However, I think it's fair to argue that any of those short run effects have played themselves out in the financial crisis and its aftermath, and now we're looking at the effects I've described.